Chances are, in the past year you’ve given serious thought to your housing situation. Spending time at home has us thankful for our space or looking at changes, and if you’ve looked at buying, you’ve seen a challenging market.
The housing market is one of the hottest areas of the economy. Low interest rates are driving housing prices higher, and there is a housing inventory shortage across much of the nation. Buyers are finding the process difficult and often making compromises.
Housing is unique because it plays such a large part in our lives. It’s a place for family, a major asset, and in the current environment - school, office, gym, etc.
It’s also different because people fall in love with real estate. Because of this emotional connection (who doesn’t want a great house!) it’s easy to isolate the decision to purchase from the rest of your financial plan, and that can be a potential mistake.
How Much House Can I Afford?
Making a smart choice with a big decision starts by looking at goals. For a home purchase different factors play a role, such as:
- How long you plan to stay in the property
- How you feel about the community and area
- Your expectations for appreciation or increases in value
- How this decision impacts your ability to build wealth
Cash flow is the keystone in home buying. It’s important to understand how much money you make and spend, as well as the borrowing standards used for mortgages.
A common rule of thumb is to limit spending to 25 percent of income on housing, this is helpful but not always useful. Instead look for the amount of spending that will also allow you to save for retirement, kids’ education costs, and other major goals.
Although, there are some good reasons you may want to stretch to the high end of this scale.
Jennifer Mack, realtor and owner of Jennifer Mack Properties, shared some insight with me "Many buyers want to be too conservative with their housing budget. Spending far less than you qualify for isn't always the smartest thing. If you want to stay in your new home for a long time and you spend far under budget, you are probably going to realize you want to move sooner than you think. Sometimes it is for more space and sometimes it is to get to a more convenient location or one with better schools."
This is great advice if you want to make a smart decision with your housing purchase. The process is too expensive and stressful to repeat often.
Qualifying for a Mortgage
When it comes to qualifying for a mortgage, lenders look at your overall financial situation and debt-to-income (DTI) ratios. Keep in mind a lender may approve you for a certain amount, but that doesn’t mean you should borrow that much. Lenders look at the following:
- Your front-end ratio, or the amount of gross income spent on housing costs. This is can be approved as high as 43% depending on the lender, it includes mortgage payments, taxes, insurance, and HOA fees, etc.
- Your back-end ratio includes all of your debt payments (housing and other) as a percentage of gross income. This amount varies by lender and can be approved as high as 50%.
What about a down payment?
A bigger down payment allows you to buy more house and provides equity in your home, it also reduces other costs like private mortgage insurance, monthly payments, fees, and interest.
And, if you are unable to stay in the home as planned, a down payment can provide a cushion against owing more than your home is worth.
The traditional requirement for a mortgage down payment is 20 percent, but today many options for a lower down payment exist. Expensive prices and low interest rates make the options worth evaluating in light of your unique financial situation.
I asked Bo Lee of Movement Mortgage her thoughts, Bo said “When you are considering buying up to your next home, it’s important to know all of the costs involved. In the DC Metro area, you can finance a home with a purchase price of up to $865,000 with as little as 5 percent down. However, if you’re looking at pricier properties, you will need a larger down payment. In addition to your down payment, you can count on paying closing costs of 2.5% - 3% of the purchase price. If you’re selling your current residence, don’t forget to account for closing costs on the sale, as well. When calculating your net proceeds, you should deduct about 1% for closing costs.”
*A good indication you are ready to purchase - you have the 20% down payment in savings already, whether you use it for financing or not.
It’s no secret that interest rates are at all-time lows. How does that translate to affordability?
The tables below show the impact interest rates can have on your monthly payment, and total interest on the loan if held until maturity.
As you can see lower interest rates are a big deal when it comes to qualifying for a loan, they stretch your dollars significantly.
It’s worth noting for comparison that a 15-year mortgage saves interest but also locks in a higher monthly payment. There is also the opportunity cost of not investing in potentially higher returning investments.
Looking for an early pay-down strategy? Consider making one extra payment per year – it may cut 7 years of the life of a 30-year loan.
Is buying a home a good investment?
Your home offers intangible benefits that are impossible to put a price on. That’s a return on investment in our lives and a good investment. Buying a house has also created wealth over time for families.
House buying is typically done with leverage – you put a relatively small amount down on a large investment. This has the effect of amplifying your return on investment.
Let’s look at how leverage works; assume you buy a house for $500,000 and put 20% down, or $100,000 – you then sell 5 years later for $550,000 banking a nice return.
This isn’t a perfect example – we need to account for fees as well as principal and interest payments over the term of the `investment, but you can see the overall point.
Over the last 20 years we’ve seen that real estate has the potential to appreciate significantly. More traditional rates of return have hovered in the 3%-5% range over time for housing.
In a competitive market, looking for value and having vision can help.
When considering value Mack shares with us, "Most homebuyers look for a turnkey property that is already updated and not in need of maintenance or repairs. Because most people want this type of home there is a lot of competition for the same homes. Prices get bid up and contingencies are waived. If you are willing to do some work on a property you will be in a much better position to not overpay and retain some contingencies (like inspection and financing). This takes some creativity but working with an experienced agent can help you see the vision of what the house could be after some work."
While interest rates make a difference in payment affordability, they are also contributing to increasing prices in markets across the country, offsetting affordability with higher sales prices.
Will we see appreciation slow or stop in housing markets when interest rates eventually rise? Areas with strong job markets and growth may face less risk, but it’s important to perform due diligence on pricing in your market and how the purchase fits your financial plan.
Putting it all Together, Working with a Great Team
Buying and selling homes is expensive and stressful. Working with a real estate team – an experienced agent, loan officer and title company – alongside your financial planner can help you make a smart decision and reduce stress.
As humans we tend to be not very good at the long-term, but we can be, and planning helps.
If you have questions, thoughts, or a story you’d like to share – please send a note. I'd love to hear from you.
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.